Determination of Forward

and Futures Prices

Chapter 5

1
Consumption vs Investment Assets
l Investment assets are assets held by a significant
number of people purely for investment purposes
(Examples: stocks, bonds, gold, silver – although a few
people might also hold them for industrial purposes for
example).

l Consumption assets are assets held primarily for

consumption (Examples: copper, oil, pork bellies) and
not usually for investment purposes.

l Arbitrage arguments will not work the same way for

consumption assets as they do for investment assets.
2
Short Selling (Page 105-106)

l Short selling or “shorting” involves selling

securities you do not own.

l Your broker borrows the securities from

another client and sells them in the market
in the usual way.

3
Short Selling (continued)

l At some stage you must buy the securities so

they can be replaced in the account of the
client.

l You must pay dividends and other benefits the

owner of the securities receives.

l There may be a small fee for borrowing the

securities.

4
Example

l You short 100 shares when the price is $100 and close
out the short position three months later when the price is
$90.

l During the three months a dividend of $3 per share is

paid.

l What is your profit?

l What would be your loss if you had bought 100 shares?

5
Example

l The profit from shorting is 100 x [ 100 – 3 – 90 ] = $700.

l Note that the dividend payment lowered the price of the

stock, and so the original owner of the stock, for whom the
dividend was intended, must be compensated for it.

l If you had bought 100 shares instead, the loss would have
been: 100 x [ –100 + 3 + 90 ] = – $700.

l The profits/losses are mirror images of one another.

6
Notation for Valuing Futures and
Forward Contracts

S0: Spot price today

F0: Futures or forward price today

T: Time until delivery date (expressed in years)

r: Risk-free interest rate for maturity T (also

expressed in years)

7
An Arbitrage Opportunity?

l Suppose that:
l The spot price of a non-dividend-paying
stock is $40.
l The 3-month forward/futures price is $43.
l The 3-month US$ interest rate is 5% per
annum.

l Is there an arbitrage opportunity?

8
An Arbitrage Opportunity? Yes.

l Suppose that you borrow $40 for 3 months at the risk-free rate
to buy the stock, and you use the money to buy the stock.

l At the same time, you enter into a short futures contract.

l In 3 months, you must deliver the stock (since you entered a

contract to sell) and you collect $43 (the futures price).

l You repay the loan of $40x(1+0.05)(3/12) = $40.49

l You get to keep: $43 - $40.49 = $2.51 with no risk/investment.

9
Another Arbitrage Opportunity?

l Suppose that:
l The spot price of a non-dividend-paying stock is
$40.
l The 3-month forward price is $39.
l The 3-month US$ interest rate is 5% per
annum.

l Is there an arbitrage opportunity?

10
Another Arbitrage Opportunity? Yes.

l Suppose that you short the stock, receive $40, and invest the
$40 for 3 months at the risk-free rate.

l At the same time, you enter into a long futures contract.

l In 3 months, you must buy the stock (since you entered a

contract to buy) and you pay $39 (the futures price).

l You receive from your investment $40x(1+0.05)(3/12) = $40.49

l You get to keep: $40.49 - $39 = $1.49 with no risk/investment.

11
 The Forward/Futures Price

§ What we conclude from the last two examples is that one

can make an arbitrage profit as the difference between the
futures prices F0 and $40x(1+0.05)(3/12) .

§ Therefore one can make an arbitrage profit by taking

advantage of the difference between F0 and S0(1+r)T.

§ To eliminate the presence of arbitrage, we must therefore

have: F0 = S0(1+r)T
12
The Forward/Futures Price

l If the spot price of an investment asset is S0 and the

futures price for a contract deliverable in T years is
F0, then:
F0 = S0(1+r)T
where r is the T-year risk-free rate of interest.

l In our examples, S0 =40, T=0.25, and r=0.05 so that

the no-arbitrage forward/futures price should be:
F0 = 40(1.05)0.25 =40.5
13
 When using continuous compounding

§ F0 = S0erT

§ This equation relates the forward price and the spot price for any
investment asset that provides no income and has no storage costs.

§ If short sales are not possible when the forward price is lower than the no-
arbitrage price, the no-arbitrage formula (continuous or regular
compounding) still works for an investment asset because investors who
hold the asset (for investment purposes but not consumption) will sell it,
invest the proceeds at the risk-free rate, and buy forward contracts.

§ If short sales are not possible when the forward price is higher than the
no-arbitrage price, however, it’s a non-issue since the strategy would call
for buying the stock (instead of short-selling it).
14
When an Investment Asset Provides
a Known Dollar Income

l When an investment asset provides income with a

present value of I during the life of the forward
contract, we can generalize the previous formula
as:
F0 = (S0 – I )erT

where I is the present value of the income during

the life of the forward contract.

15
When an Investment Asset Provides
a Known Dollar Income: Example

l Consider a 10-month forward contract on a $50 stock, with a

continuous riskless rate of 8% per annum, and $0.75
dividends expected after 3 months, 6 months, and 9 months.

l The present value of the dividends, I, is given by:

I = 0.75e-0.08x3/12 + 0.75e-0.08x6/12 + 0.75e-0.08x9/12 = 2.162

l The no-arbitrage forward price therefore must be:

F0 = (50-2.162) e0.08x10/12 = $51.14

16
When an Investment Asset Provides
a Known Yield
l Sometimes the underlying asset provides a known yield
rather than a known cash income.

l The yield can be viewed as the income as a percentage of

the asset price at the time it is paid.

l The no-arbitrage formula then becomes:

F0 = S0 e(r–q )T
where q is the average yield during the life of the contract
(expressed with continuous compounding)
17
When an Investment Asset Provides
a Known Yield: Example
l Consider a 6-month forward contract on a $25 asset
expected to produce a yield per annum of 3.96%, and a risk-
free rate of 10%.
l The no-arbitrage price thus is: 25e(0.10-0.0396)x0.5 = $25.77

l Note that if you were not given the continuous yield directly but told that
the income provided would be equal to 2% of the asset price during a 6-
month period, you would need to convert from discrete to continuous:
l 2% in 6 months is equivalent to 3.96% per annum for 6 months with
continuous compounding, because: 1+0.02 = eq(1/2)
l Backing out q as 2ln(1+0.02) we get q = 0.0396

18
Valuing a Forward Contract

l A forward contract is worth zero (except for bid-offer spread

effects) when it is first negotiated.

l Banks are required to value all the contracts in their trading

books each day, as later the contract may have a positive or
negative value.

l Suppose that K is the delivery price and F0 is the forward price

for a contract that would be negotiated today.

l The delivery is in T years from today and the continuously

compounded risk-free rate is r.
19
Valuing a Forward Contract

l By considering the difference between a contract with delivery price K and a

contract with delivery price F0 we can deduce that:

l The value, f, of a long forward contract is

f = (F0 − K)e−rT or f = S0 − Ke−rT

l The value of a short forward contract is

f = (K – F0 )e–rT or f = Ke−rT – S0

l If the asset provides a known income with present value I or a known yield q,
for a long forward contract position, we have:
f = (F0 − K)e−rT or f = S0 − I − Ke−rT

or f = (F0 − K)e−rT or f = S0e−qT − Ke−rT

20
Valuing a Forward Contract: Intuition

l Suppose that, a while back, you entered into a long futures

contract to buy an asset for K.

l Today, the same futures contracts has a price F0 that

happens to be higher than K.

l The older futures contract that you entered allows you to

only pay K instead of the higher F0 at expiration, a value or
benefit at expiration equal to F0 -K.

l Thus the present value today of that benefit is:

f = (F0 − K)e−rT
21
Valuing a Forward Contract: Intuition

l Suppose that, a while back, you entered into a short futures

contract to sell an asset for K.

l Today, the same futures contracts has a price F0 that

happens to be lower than K.

l The older futures contract that you entered allows you to

receive K instead of the lower F0 at expiration, a value or
benefit at expiration equal to K-F0.

l Thus the present value today of that benefit is:

f = (K − F0)e−rT
22
Forward vs. Futures Prices

l When the maturity and asset price are the same, forward
and futures prices are usually assumed to be equal.
(Eurodollar futures are an exception, we will see this later).

l When interest rates are uncertain, futures and forward prices

are, in theory, slightly different:
l A strong positive correlation between interest rates and the asset price
implies the futures price is slightly higher than the forward price.
l A strong negative correlation implies the reverse.

l For most practical purposes, however, we will assume that

forward and futures prices are the same, equal to F0.
23
Stock Index (Page 116)

l Can be viewed as an investment asset

paying a dividend yield.

l The futures price and spot price relationship

is therefore
F0 = S0 e(r–q )T
where q is the dividend yield on the portfolio
represented by the index during the life of
the contract.
24
Stock Index (continued)

l For the formula to be true, it is important that the

index represent an investable asset.

l In other words, changes in the index must

correspond to changes in the value of a tradable
portfolio.

l The Nikkei index viewed as a dollar number does

not represent an investment asset, since Nikkei
futures have a dollar value of 5 times the Nikkei.
25
Stock Index: Example

l Consider a 3-month futures contract on the S&P

500 index where the index yields 1% per annum.

l The current index value is 1,300 and the

continuously compounded riskless rate is 5%.

l The futures price F0 must be: 1,300e(0.05-0.01)x0.25

l Thus F0 = $1,313.07

26
Index Arbitrage

l The arbitrage strategies are the same as when

dealing with an individual security.

l When F0 > S0e(r-q)T an arbitrageur buys the stocks

underlying the index and sells futures.

l When F0 < S0e(r-q)T an arbitrageur buys futures

and shorts or sells the stocks underlying the
index.
27
Index Arbitrage (continued)

l Index arbitrage involves simultaneous trades in the index

futures contract and in many different stocks.

l Very often a computer is used to generate the trades: this

is an example of program trading, the trading of many
stocks simultaneously with a computer.

l Occasionally simultaneous trades are not possible and the

theoretical no-arbitrage relationship between F0 and S0
does not hold, as on October 19, 1987 (“Black Monday”).

28
 Futures and Forwards on
Currencies (Page 117-121)
l A foreign currency is analogous to a security providing a
yield because the holder of the currency can earn interest
at the risk-free interest rate prevailing in the foreign
country.

l The yield is the foreign risk-free interest rate.

l It follows that if rf is the foreign risk-free interest rate,

( r −rf ) T
F0 = S0e
29
Explanation of the Relationship
Between Spot and Forward
1000 units of
foreign currency
(time zero)

r T
1000e f units of 1000S0 dollars
foreign currency at time zero
at time T

r T 1000S0erT
1000 F0 e f
dollars at time T dollars at time T

30
 Arbitrage in Foreign Exchange
Markets
l Suppose that the 2-year interest rates in Australia and
the United States are 5% and 7%.

l The spot exchange rate is 0.62 USD per AUD.

l The 2-year forward exchange rate or price should be:

0.62e(0.07-0.05)x2 = 0.6453

l What is the arbitrage if the forward rate is 0.63?

l What is the arbitrage if the forward rate is 0.66?

31
 Arbitrage in Foreign Exchange
Markets
l If the forward rate is 0.63, the forward is underpriced (<0.6453).
l Take a long position in the forward contract: an agreement to
buy AUD in 2 years at the rate of 0.63
l Borrow 1,000 AUD today @ 5% per year, convert the amount
immediately to 1,000x0.62 = 620 USD and invest @ 7%.
l Two years later, 620 USD grow to 620e0.07x2 = 713.17 USD.
l Must repay the AUD loan: owe 1,000e0.05x2 = 1105.17 AUD.
l Use the forward to buy 1105.17 AUD, costing 1105.17x0.63 or
696.26 USD and repay the loan balance of 1105.17 AUD.
l Keep the difference 713.17 – 696.26 = 16.91 USD.

32
 Arbitrage in Foreign Exchange
Markets
l If the forward rate is 0.66, the forward is overpriced (>0.6453).
l Take a short position in the forward contract: an agreement to sell
AUD in 2 years at the rate of 0.66
l Invest in AUD today by first borrowing 1,000 USD @ 7% per year and
converting the amount immediately to 1,000/0.62 = 1,612.90 AUD.
Therefore invest 1,612.90 AUD @ 5%.
l Two years later, 1,612.90 AUD grow to 1,612.90e0.05x2 = 1,782.53
AUD.
l Must repay the USD loan: owe 1,000e0.07x2 = 1,150.27 USD.
l Use the forward to sell 1,782.53 AUD, giving you 1,782.53x0.66 or
1,176.47 USD and repay the loan balance of 1,150.27 USD.
l Keep the difference 1,176.47 – 1,150.27 = 26.20 USD.
33
Futures on Commodities that are
Investment Assets (Gold, Silver, …)
l With commodity futures, one has to take into account
possible storage costs of the commodity (because
implementing an arbitrage strategy might imply the buying –
and thus the storing – of the commodity).
l Storage costs can be viewed as negative income or yield.
l Letting u be the storage cost per unit time as a percent of
the asset value, we have:
F0 = S0 e(r+u )T
l Alternatively, letting U be the present value of the storage
costs, we have:
F0 = (S0+U )erT

34
Futures on Commodities that are
Consumption Assets (Copper, Oil, …)
l With commodities that are consumption assets, if the futures price is
above the no-arbitrage level, one sells the futures and buys the
underlying commodity, driving prices back in equilibrium.
l However, if the futures price is below the no-arbitrage level, the
arbitrage strategy would entail buying the futures and selling the
underlying commodity. But if held for consumption purposes, it won’t
be sold. Thus the futures price will stay below its no-arbitrage level.
l Letting u be the storage cost per unit time as a percent of the asset
value, we therefore have:
F0 ≤ S0 e(r+u )T
l Alternatively, letting U be the present value of the storage costs, we
therefore have:
F0 ≤ (S0+U )erT

35
Convenience Yield

l With consumption asset commodities we thus have:

F0 ≤ S0 e(r+u )T

l Therefore the difference between F0 and S0 e(r+u )T can be

viewed as reflecting the convenience of holding the physical
consumption asset (rather than the futures contract on it).

l So if we let y be the parameter that will equate the two:

l we then must have: F0 eyT = S0 e(r+u )T
l y is referred to as the convenience yield, and we have:
F0 = S0 e(r+u -y)T
36
 The Cost of Carry (Page 124)

l The cost of carry, c, is the interest cost - income

earned + storage costs, so c = r – q + u

l For an investment asset F0 = S0ecT

l For a consumption asset F0 ≤ S0ecT

l The convenience yield on the consumption asset,

y, is defined so that
F0 = S0 e(c–y )T
37
Futures Prices & Expected Future
Spot Prices
l Suppose k is the expected rate of return required by
investors on an asset.

l We can invest F0e–r T at the risk-free rate and enter into a

long futures contract to create a cash inflow of ST at
maturity.

l This shows that:

F0 e − rT = E ( ST )e − kT or F0 = E ( ST )e ( r − k )T

38
Futures Prices & Future Spot Prices

No Systematic Risk (β=0) k=r F0 = E(ST)

Positive Systematic Risk (β>0) k>r F0 < E(ST)
Negative Systematic Risk (β<0) k<r F0 > E(ST)

Positive systematic risk: stock indices (Normal Backwardation)

Negative systematic risk: gold (at least for some periods, Contango)

However, the terms backwardation and contango are also often used to
describe whether the futures price is below or above the spot price S0.

39